Contents - AL-Tax

3.5 Profit Split Methods 31the discounted cash flow (DCF) method and the market comparison method haveconsiderably more merit from an economic standpoint.In sum, the magnitudes that are allocated under the residual profit split method,and the approximations of relative asset values used for purposes of allocating residualincome, are incorrectly defined and inaccurately measured.3.5.2 Comparable Profit Split MethodConsider next the comparable profit split method.3.5.2.1 Description of Comparable Profit Split MethodIn principle, the U.S. regulations favor the comparable profit split method over theresidual profit split method because it relies more heavily on external market benchmarks.26 The comparable profit split method entails constructing a “hypothetical”multinational firm from two unrelated firms considered comparable to two individualmembers of a controlled group. Comparability, in this context, requires thateach of the two unrelated companies artificially joined together engages in similaractivities, employs similar resources (as measured by the book value of tangibleassets), and incurs similar risks as the affiliated company with which it is paired.The combined operating profits of the two unaffiliated companies should not “varysignificantly” from the combined operating profits of the affiliated companies withwhich they are being compared. Under these circumstances, one can quantify theproportional division of combined before-tax operating income between the unaffiliatedcompanies, and apply the same proportion to the before-tax operating incomeearned jointly by the affiliated companies to determine their individual taxableincome. Practitioners rarely use the comparable profit split method, because pairsof sufficiently comparable companies can rarely be found.3.5.2.2 Underlying Economic RationaleThe comparable profit split method rests more on analogy than economic reasoning.It presupposes that the division of labor and risks between two unaffiliatedcompanies, coupled with the book value of their respective assets, enables one toinfer the relative fair market value of assets (both tangible and intangible) that eachemploys. Stated differently, the comparable profit split method presupposes that, iftwo pairs of unaffiliated companies divide functions and risks between themselves,and individually have approximately the same book value of assets, as their respectiveaffiliated opposite number, the relative fair market value of assets across pairswill likewise be the same.26 See Treas. Reg. Section 1.482-6(c)(2)(ii)(D)) and Treas. Reg. Section 1.482-6(c)(3)(ii)(B).